2023 year-end tax planning opportunities for hospitality and consumer businesses
As another year comes to an end, there are some major tax opportunities and concerns impacting the hospitality and consumer industries that should be considered for planning purposes. Although many COVID-19 related programs and changes are behind us, there are other important areas to consider that can impact your business decisions before year-end. Below are some of those key items that we are paying close attention to and will help guide discussions with your tax advisors.
2022 was the last year taxpayers could utilize the 100% bonus depreciation deduction for qualifying property such as machinery, equipment, furniture, and qualified improvement property (QIP). QIP is any improvement to the interior portion of a commercial building done after the building was initially placed in service is considered QIP. However, work to an elevator or escalator, building expansion, or work done to the “structural framework” of the building, is not included. QIP is very common in the hospitality and consumer industries as many restaurants and retailers make interior improvements on a regular basis.
However, starting in 2023, the bonus depreciation benefit starts to decline with the deduction now reduced to 80% and then by an additional 20% each subsequent year until it is fully phased out in 2027.
This means operators planning large asset purchases or interior upgrades should consider buying and placing such assets in service before year-end to utilize a larger bonus depreciation deduction. Cost segregation studies can also be completed to do an in-depth analysis of the fixed asset additions to help ensure all assets are properly classified as 5, 7, 15, or 39-year properties.
Below is a chart that provides the breakdown of bonus depreciation rates based on the date the property was placed in service:
|General qualified property for bonus
|9/28/2017 - 12/31/2022
|2027 and after
Pass-through entity taxes
Beginning with the 2018 tax year, the Tax Cuts and Jobs Act (TCJA) implemented a $10,000 limitation on the state and local tax (SALT) deduction that can be utilized by individuals on their personal federal income tax returns. In contrast, prior to the TCJA, individuals were able to deduct for federal purposes all state and local taxes paid, subject to alternative minimum tax and itemized deduction limits. As expected, the introduction of the $10,000 cap resulted in a significant increase of the federal income tax liability for a lot of taxpayers in high income tax states such as New York, Connecticut, and California, which partially led many high-net-worth individuals to flee to more favorable or no income tax jurisdictions. This forced many states to look for solutions that would provide a relief and reduce impacts on the new SALT cap. The pass-through entity (PTE) tax achieves exactly that by providing a workaround to the limitation. By opting into the PTE tax, a qualifying business entity is choosing to pay the PTE tax on behalf of its eligible members or shareholders. This allows the entity to take a federal tax deduction for the PTE taxes paid, which in turn reduces the taxable income reported on each eligible participant’s K-1s. In addition, those members or shareholders receive a tax credit for their share of the taxes paid on their behalf that can generally be utilized to reduce the taxes due on their personal state income tax returns.
As of November 2023, the AICPA listed 36 states and one locality that have enacted their own PTE tax legislation. It is important to check your state’s specific PTE rules to confirm eligibility requirements as the rules vary by each jurisdiction (i.e., some states require all partners or shareholders of the entity to be individuals). In addition, there are some states where the PTE tax election is mandatory. Lastly, states may have different due dates on when the PTE tax election must be made, as well as different guidelines on whether the state requires estimated tax payments, and how much of the PTE tax credit can be utilized to offset state income tax. Please reach out to your tax advisor to discuss further.
Now more than ever, it is important to ensure your business is compliant with state nexus rules. During the pandemic, many employees started working from home or relocated to another state, while many businesses began to explore the benefits of using a virtual workforce. All of this has the potential to create nexus in new states due to physical presence within the state, which can result in additional filing requirements and tax implications.
In 2018, the U.S. Supreme Court issued its decision in Wayfair, which established that certain economic contacts with the state were sufficient to establish nexus when no physical presence exists. Each state has different rules and thresholds regarding nexus for sales and use tax, as well as income tax. Companies can undergo nexus studies to help ensure they are compliant in the states where they have employees, inventory, high sales, etc. State nexus compliance is one of the key items reviewed as part of the transaction’s due diligence, as buyers want to make sure they are aware of any pitfalls and additional potential state tax liability, including interest and penalties due to non-filing of the required state returns. The state tax rules can be extremely complex, so it is crucial to speak to your tax advisor before you begin operating in a new state to be aware of the tax impacts.
Section 174 research and experimental expenses
Effective Jan. 1, 2022, the treatment of specified research and experimentation (SRE) costs changed under Section 174. Historically, qualified research expenditures (QRE) under Section 41 were only domestic costs and were subject to a four-part test (qualified purpose, process of experimentation, technological in nature, and elimination of uncertainty). Under Section 174, SRE costs are more inclusive now compared to the historical definition of research and experimental costs and includes ancillary items that companies may not be aware are indirectly related to R&E activities. Examples of SRE costs include labor costs, certain software development costs, patent costs, travel costs, and materials and supplies costs. Additionally, most business entities were able to deduct QREs as incurred under the prior regulations. However, as of Jan. 1, 2022, domestic SRE costs must be capitalized and amortized over five years, and international SRE costs must be capitalized and amortized over 15 years. Another key item to mention is that there is no deduction allowed upon disposition, retirement, or abandonment of the project. This could be a significant change for many business entities and could cause taxable income for some entities that historically had losses.
This may also have state tax implications and could cause unexpected balances. There are some states that have not conformed to the federal tax treatment of SRE costs, which could lead to state modifications. Please consult your tax advisor to determine if your business is subject to the Section 174 regulations and if there are any state tax implications for your entity as well.
Section 163(j): Business interest expense limitation
IRC section 163(j), another unfavorable change introduced by the Tax Cuts and Jobs Act, limits the amount of interest expense that can be deducted in a tax year. The limitation applies to certain taxpayers that are considered tax shelters or with average annual gross receipts for the prior three years over $29 million for 2023 ($27 million for 2022). From the 2018 to 2021 tax years the interest expense deduction was generally limited to 30% of adjusted taxable income (ATI), which is similar to the calculation for EBITDA.
Starting in 2022, the calculation of ATI changed as it no longer included an addback for depreciation and amortization. This was not beneficial for hospitality and consumer clients as depreciation is typically one of the largest expenses of the business. Since depreciation and amortization is no longer an addback for ATI, more of the interest expense could potentially be limited. Any interest expense that cannot be utilized will be carried forward on the tax return and can be deducted when the entity has sufficient ATI.
Taxpayers should confirm they have complied with these rules and the change in the ATI calculation and should also consider nondeductible interest expense when calculating the year end projections for entities and their owners.
Accounting method changes
Taxpayers whose average annual gross receipts for three years prior to 2023 are below $29 million are considered small business taxpayers and can access certain benefits by filing an Application for Change in Accounting Method, IRS Form 3115. These benefits could potentially include a full interest expense deduction without a limitation for the Section 163(j), use of the cash method of accounting, exemption from the uniform capitalization rules, and, important for restaurants, the ability to treat inventories as nonincidental materials and supplies.
Establishing a gift card company (Giftco) in a favorable jurisdiction to minimize the risk of having to escheat unredeemed/unexercised gift cards/certificates for unclaimed property compliance purposes should be considered. To this end, unclaimed property has become an important area of concern for many businesses, especially in the hospitality industry. That is, companies are wrestling with unclaimed property issues related to unredeemed gift certificates/cards, including the timing for remitting the unclaimed property, the amount to escheat, the jurisdiction to which funds must be remitted, and the associated record-keeping requirements in order to be in compliance with states’ reporting obligations.
A planning opportunity exists whereby a specific purpose entity is formed in a favorable jurisdiction, which does not escheat unexercised gift cards/gift certificates. There are roughly 32 states that have favorable unclaimed property rules that would need to be analyzed to assure optimum benefits are realized, both from an unclaimed property as well as from a tax perspective.
In general, the gift card management strategy would involve forming Giftco in one of the favorable jurisdictions and then transferring unexercised gift certificates/cards into the newly form entity, thus allowing the transferor the potential to avoid having these items become escheatable, provided they are transferred prior to the expiration of the dormancy period on such property. In addition, all future sales of gift cards/certificates by Giftco would be governed by the unclaimed property rules in state in which Giftco was formed, thereby minimizing prospective unclaimed property tax liabilities and compliance burdens.
As mentioned above, you should review how your state conforms to these tax opportunities and changes, and availability of any state specific tax credits. These are just a few items to consider when doing year-end tax planning that could save your hospitality or consumer business money during today’s challenging times.
Subject matter expertise
CPA, Manager, Tax
CPA, Senior Manager, Tax
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.